Critique of the Rationale for the Act

The
1977 report by the Insurance Bureau and the earlier work by the Federal
Insurance Administration exaggerated problems in the insurance market and did
not devote sufficient attention to the benefits of competitive underwriting,
risk classification, and claim settlement. Substantial restrictions on
underwriting and rating adopted in the Essential Insurance Act and in other
states have
significant drawbacks.
[29]

Competitive Underwriting and Risk Classification. Many factors
affect the expected costs of accidents for a given driver. The probability and
likely cost of damages from an accident will depend on factors such as traffic
density, road conditions, the cost of hospitalization, and the cost of vehicle
repair parts. They also will be affected by the precautions taken by persons to
avoid accidents and to reduce the cost of accidents that do occur. Possible
precautions include deciding not to drive, deciding to drive less, purchasing a
more crash worthy vehicle, maintenance of vehicle safety, driving more slowly,
not driving after consumption of alcohol, paying close attention to traffic
conditions and traffic controls, etc. A driver's expected accident costs also
depend on his or her honesty and integrity. Drivers are likely to vary
significantly in their tendency to create fraudulent losses, inflate claim costs following an accident, or both.

The major economic
justification for allowing insurers substantial discretion in underwriting and
risk classification is that it provides incentives for drivers and insurers to
control claim costs in an efficient manner.
[30] Insurance is a loss-sharing
mechanism. Policyholders in a given group with greater than average claim costs
during the coverage period essentially have their claims paid by their own
premiums and by a portion of the premiums of policyholders with lower than
average claim costs. While it is customary for the insurer to bear the risk of
unanticipated changes in the average cost of losses for a given group during the
coverage period, anticipated changes in the cost of coverage over time will be
reflected in premiums and thus borne by policyholders. Underwriting and risk
classification determine the scope of loss sharing among policyholders.

Competitive pressure and
policyholder preferences provide insurers with the incentive to sort
policyholders into the most homogeneous groups possible subject to constraints
on the availability and cost of information. The desire by policyholders for the
lowest possible premium creates the incentive for insurers to reduce rates for
drivers with lower than average expected accident costs. As a by-product,
premiums for drivers who on average will have higher accident costs will
increase. Any insurer that did not engage in risk classification to sort
policyholders into the most homogeneous groups possible would lose customers
with lower than average expected costs to competitors, attract customers with
higher than average expected costs, or both. The insurer would need to raise
rates, engage in classification, or both to survive.

Competitive risk assessment
does not produce perfect accuracy in the sense that each policyholder pays a
premium commensurate with his or her expected loss. Due to inherent constraints
on knowledge and the cost of information, some heterogeneity will exist in any
rating class (i.e., expected accident costs will not be identical for all
policyholders in the class). However, competitive underwriting and rate
classification will produce the greatest possible accuracy given such
constraints. The resultant system of "cost-based pricing" has a persistent
tendency to achieve two related results over time: First, in any rating class it
will not be possible ex ante to distinguish drivers with higher than
average expected accident costs from drivers with lower than average expected
accident costs at a cost that would justify obtaining the information necessary
to do so (assuming that such information existed). Second, actual losses will
differ significantly between rating classes, but on average it will not
be possible ex post to identify subgroups within a class that have
experienced significantly different losses using information that could have
been obtained at low cost prior to the period of coverage. As such, competitive
risk classification operates over time to eliminate "cross-subsidies" among
policyholders to the extent that it is cost efficient to do so.

Given discretion, some insurers will engage in
"subjective" underwriting. Some of the characteristics that are related to
expected accident costs or underwriting expenses are difficult to measure or
quantify with objective tests. Examples include an applicant's proclivity to
engage in fraud or the likelihood that an applicant will pay subsequent premium
installments. In a perfect world, subjective underwriting would not exist, but
then neither would claims fraud or nonpayment of premiums. While many observers
regard any form of subjectivity as objectionable, it is important to stress that
competition will only reward subjective judgment to the extent that it helps to
identify policyholders who on average will have either higher or lower claim
costs. Erroneous judgments either will be penalized by adverse loss experience
(e.g., if the subjective assessment understates expected claim costs), or they
will result in an unnecessary loss of sales for the insurer and agent (e.g., if
the assessment overstates expected claim costs). As a result, competition will
prevent the widespread use of arbitrary underwriting and rating criteria over
time. Moreover, subjective underwriting that does occur in states that allow
insurers a large degree of discretion in underwriting and rate classification
does not result in a large involuntary market (see below).

Significant restrictions on
risk assessment are likely to be costly because they distort incentives for
claim cost control by drivers, insurers, and policymakers. First, cost-based
pricing provides desirable incentives for policyholders to take precautions to
reduce expected accident costs. Second, if an insurer bears sole responsibility
for the claim costs of its policyholders, it has a strong incentive to minimize
the sum of claim costs and the cost of claim settlement.
[31] As is
discussed further below, reinsurance facilities and joint underwriting
associations, which involve pooling of claim costs among insurers, are likely to
reduce the incentive for efficient claims settlement. These mechanisms are more
likely to be used if restrictions on underwriting and rate classification are
adopted. Third, when confronted with rising claim costs and affordability
problems, policyholders and insurers have incentives to influence legislation to
control claim costs and thus premium growth in efficient ways.
[32] Substantial
restrictions on underwriting arid rate classification also distort these
incentives.

Causes of Large Involuntary Markets. Given
substantial discretion in underwriting and rate classification, almost all
policyholders are able to obtain coverage in the voluntary auto insurance
market, and cyclical fluctuations in prices and the supply of coverage are
likely to have only a minor impact on the proportion of drivers insured in the
involuntary market.
[33] Instead, there are two principal causes of large
involuntary markets: (1) inadequate involuntary market rates that compete with
and crowd out the voluntary market, and (2) voluntary market rate regulation
that produces inadequate rates and thus makes insurers unwilling to write
coverage voluntarily.
[34]

Table 5

Involuntary Market as a Percent of Total
Market in 1987(Private Passenger Auto Liability)

Table 5 presents
information on the size of the involuntary market in Michigan and
other states in 1987. Seventeen states had involuntary market shares (of
total insured car-years for liability coverage) greater than or equal to three
percent. Michigan ranked 17th with an involuntary market share of 3 percent.
Twenty-eight states had less than one percent of insured vehicles in the
involuntary market. Fifteen of these states (including the neighboring states of Illinois, Indiana, Ohio, and Wisconsin) had less than one tenth of one percent
of insured vehicles in the involuntary market. The five states with the largest
involuntary market shares each have substantial restrictions on underwriting and
rate classification, restrictive voluntary and involuntary market rate
regulation, or both. Most of the other states with greater than one percent of
insured vehicles in the involuntary market regulate voluntary market rates or
are likely to hold involuntary market rates below the expected cost of providing
coverage for some groups.

The 1977 report by the Insurance Bureau emphasized an increase in the number of applications in the Michigan assigned risk plan, but it did not mention the share of vehicles insured in this plan.[35]Figure 3 shows the percentage of vehicles insured in Michigan's involuntary market each year from 1973 to 1987. As can be seen, the
percentage increased sharply in 1977. However, at its peak in 1978, the
involuntary market accounted for just over four percent of total insured
vehicles. The involuntary market share declined to just over two percent by
1980, the year prior to the effective date of the Essential Insurance Act.
[36]

Between 1975 and 1977, the
involuntary market share in Illinois increased from 0.44 percent to 1.04
percent. It declined in 1978. Ohio's involuntary market share increased from
0.18 percent in 1975 to 0.20 percent in 1977; it declined in 1978.[37] Why was Michigan's involuntary market share and the increase in its share larger than for its industrial neighbors during this period? The most likely causes are either lags in voluntary market rate approval during a period of rapid growth in claim costs, inadequate involuntary market rates, or both.
[38]